Who pays taxes within an S corporation? Shareholders pay taxes, but they only pay taxes upon filing their personal tax returns. An S corp is notable for its pass-through taxation method, where profits and losses shift from the business to the individual tax returns of its shareholders. Shareholders note the business activities on their individual tax returns and pay the taxes owed.

In essence, an S corp operates in the same manner as a corporation, but the shareholders are taxed on an individual basis. S corps also do not pay business income taxes. S corps are the fastest-growing entities because they are a popular option among small business owners.

An S corp is a domestic entity designated as a pass-through business, and it is not a legal entity. However, S corp come with certain restrictions, such as:

  • S corps cannot have more than 100 shareholders.
  • Shareholders must be permanent residents or U.S. citizens.
  • Other entities cannot own an S corp.

S corp generally face high marginal tax rates when it comes to individual wage earing. With that, the amount of taxes paid depends on a shareholder’s stake in the business. Active shareholders participate in the daily operations of the corporations, while passive shareholders have no direct involvement in business affairs.

Moreover, all shareholders must pay federal income taxes at marginal rates, including local and state income states. State and local income taxes may vary from 0 to 13.3 percent. A key difference in how shareholders are taxed is in regards to payroll taxes, which is the tax that funds Medicare and Social Security. Active shareholders receive two different income types from an S corp: profit wage and distribution.

Wage income is open to payroll taxation, which amounts to 15.3 percent on the following income levels:

  • 15.3 percent at the first $117,000
  • 2.9 percent on the following $83,000
  • 3.8 percent on income more than $200,000

In addition, profit distributions are not subject to payroll taxes. If a shareholder gets $200,000, and half of the amount comprises wage income, the shareholder would need to pay $15,300 (15.3 percent of $100,000), and the remaining would not be taxed.

The IRS establishes various guidelines to prevent abuse. For instance, the IRS wants to curb activity that would dispense as much profit as needed, while recording as little wages as possible. This is why the IRS mandates that shareholders working as employees be paid a reasonable salary. This means that the shareholder’s salary must be comparable to the average pay scale that the job position entails.

On the other hand, passive shareholders do not adhere to payroll taxes because they don’t take wages from the corporation. Rather, they must pay the Net Investment Income taxes, which stands at 3.8 percent, and the tax only applies to income sources more than $200,000 ($250,000 regarding joint marriage filings). Therefore, passive owners may face higher tax rates than shareholders in active status.

Form 1120S is applied with an S corp’s yearly tax return, and Form 1120 is applied to a C corpsSchedule K and Schedule K-1s are used to reveal the various income and deductions that are dispensed among the shareholders.

Employment Taxes

Regardless of your employment status, you need to pay Medicare and Social Security taxes. If you work for an employer, you only need to pay a portion of the taxes, and your employer pays the remaining balance. With that, if you are self-employed, you must pay the entire tax balance. A combined employer-employee amount runs up to 15.3 percent, but the rate had dropped recently.

If you choose an S corp, you may classify a portion of your income as distribution and salary. In addition, you must still pay self-employment taxes on the salary that’s part of the income stream, but you would only pay standard income taxes on the distribution end.  Moreover, you could save on self-employment taxes through the conversion of an S corp.

  • Note: It’s worth noting that the IRS tends to scrutinize S corp-based tax returns because there’s too much wiggle room for abuse. For instance, if you make $500,000 yearly, but only note $20,000 of that as a salary, you may get an IRS response because you are trying to get around paying hefty self-employment taxes.

Who pays taxes within an S corporation? To learn more,  submit your legal inquiry to our UpCounsel marketplace. UpCounsel’s lawyers will give you a helping hand when it comes to S corp taxation and choosing the right business structure that suits your business goals. In addition, they will help you through tax filings and ensure that you properly deduct and classify your business expenses and income the right way.